UK plunged into uncertainty

Market analysis
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09/06/2017

No US economic data appeared this week to throw light on recent weak job creation figures.

The first quarter slowdown was in part technical, but the second quarter rebound looks only modest. However, statistics showing that unfilled positions rose sharply in April -to a little over 6 million- suggest that slow job creation is perhaps linked to skill shortages. After all, the US is running at what is considered full employment. As a result, wage growth, which has so far been sluggish, could pick up speed in coming months.

The ECB has revised down its inflation outlook for the eurozone and slightly lifted growth prospects. The bank is more confident about the recovery's solidity and considers that risks to its growth scenario are now evenly balanced, rather than falling. It no longer thinks benchmark rates might move back lower. Even so, it expects inflation only to rise very slowly, a reminder that monetary policy will remain accommodating for some time. The big question, therefore, is at what pace the ECB will start tapering its bond buying programme in 2018, if indeed it does decide on this option. In our view, a move is highly likely.

Theresa May unexpectedly lost her parliamentary majority, an election upset that will bring fresh uncertainty. Will a new government be formed? Will the UK’s Brexit approach be reviewed? The election results make us think that uncertainty in the UK will last for some time so it would be premature to try to benefit from sterling’s big fall. We remain neutral on UK assets.

European equities

European markets lost ground as the geopolitical situation became more complicated. First, there was the terrorist attack in London, followed by the Conservative party losing its parliamentary majority in the elections, an event that will inevitably raise more questions over the Brexit talks. In addition, the ECB revised down its outlook on inflation for 2017.

Most sectors ended the week lower, apart from banks which found some comfort in the fact that Banco Popular was saved from collapsing.

New US car registrations edged lower in May but Europe remained buoyant. Daimler said sales had jumped 12.3% with Europe and China rising 14% and 32% respectively while the US was down 8%. Renault’s CEO Carlos Ghosn is looking for someone to take over from him as head of Renault-Nissan.

Rémy Cointreau’s full-year earnings swept past expectations due to growth in upmarket cognac. The group has raised its guidance on margins in 2019-20 after a year of strong momentum in the US and signs that China is really recovering. WPP said April sales were slightly below expectations but reaffirmed its forecast of annual sales rising 2%. Air France remained upbeat in May with global passenger traffic up 6.1%. Unit revenues rose for the second month in a row.

In M&A, L’Oréal said it had received a firm bid from Natura Cosmeticos for The Body Shop and was starting exclusive talks. It was confirmed that Alexandre Bompard would replace George Plassat as CEO of Carrefour from June 16.

US equities

The S&P edged 0.2% lower but was still well above the 2,400 mark. The Nasdaq, meanwhile, pushed higher to hit fresh highs. Last week saw a batch of macroeconomic data, culminating in a clearly disappointing 138,000 in non-farm payrolls when analysts were expecting 182,000. The main event this week was non-manufacturing ISM which came in at 56.9 compared to expectations of 57.1.

Elsewhere, markets focused on former FBI head James Comey’s senate hearing. He said Donald Trump had applied tacit pressure to stop FBI investigations but stopped short of claiming he had received clear threats. Obstruction of justice is a constitutionally rigid concept in the US so his testimony is unlikely to trigger or even fuel the impeachment procedure.

US hedge funds were shown to have historically high concentrations in tech stocks (100th percentile). This means the sector would be highly vulnerable to any operational disappointments. In contrast, the same hedge fund are largely underweight financials and energy (6th and 4th percentiles respectively) which would explain the market's recent resistance to fresh falls in the price of crude oil.

Japanese equities

The TOPIX dropped 0.9% over the week and markets softened although the Nikkei 225 hit the 20,000 mark last Friday for the first time in 18 months. The decline was due to disappointment over a downward revision in Japan’s GDP data for January-March, news that the BoJ was struggling to lay out stimulus exit strategy scenarios and also by investors selling before the UK general election. However, domestic demand-oriented small and mid-cap stocks which are less likely to be affected by overseas events were relatively firm due to non-domestic buying.

The best performing sectors were Fishery, Agriculture & Forestry (+2.2%) and Air Transportation (+1.7%). Toshiba soared 10.8% on the news that the US tech firm Broadcom was eyeing the company’s flash memory business.

Emerging markets

China’s May exports rose by 8.7% and imports 14.8%, both above expectations as analysts had pencilled in +7.3% and +8.3% respectively. Real import growth suggests domestic demand is still strong.

Alibaba revised up its revenue growth guidance to 45/49%, or around 10% above consensus. The company will introduce brand databanks to provide targeted advertising solutions and unified ID across platforms. Most of China’s internet, auto and education plays performed well this week.

April inflation was 3% but despite lowering its inflation outlook, the Reserve Bank of India left its repo rate unchanged at 6.25% in order to keep inflation close to 4%. To boost the property sector, the bank also lowered risk weights for housing loans for ticket sizes in the range of INR 3/7.5m (EUR 40,000-105,000) to 35% from 50% previously and for loans above INR 7.5m to 50% from 75%. Provisioning requirements were lowered to 0.25%.

In Brazil, the big news was the Superior Electoral Court’s decision over alleged illegal campaign funding by the Rousseff-Temer ticket, which could remove Michel Temer from the government. The final result was expected on Saturday. Elsewhere, the Senate’s Special Commission approved the Labour Reform package and it should go before parliament between June 20 and 25. The Central Bank of Brazil released a dovish inflation statement and indicated that interest rates could continue to fall.

In Argentina, consumer inflation finally slowed from 2.6% in April to 1.3% in May.

Peru’s central bank surprised the market by keeping rates unchanged.

Commodities

Brent crude sank 5% to USD 47, its lowest level since November 30 2016 when OPEC unveiled its production cuts. It has now fallen more than 10% in three weeks.

There are several reasons for this. First, the decision by Saudi Arabia, Egypt, the UAE and Bahrain to break off diplomatic relations with Qatar which is accused of supporting terrorist groups and the Muslim brotherhood in an attempt to destabilise the region. Saudi Arabia has also accused Qatar of enjoying good relations with Iran. Qatar is only a small oil producer (620,000 b/d) so we believe there is little chance this development will jeopardise the OPEC agreement. Second, the US Department of Energy’s weekly data showed that US inventories had risen sharply at the beginning of the high-demand driving season.

The rise should be put into perspective, however:

1/ markets pay too much attention to highly volatile weekly data

2/ the rise was only 3.3 million barrels after a 6.4 million drop last week

3/ a long weekend next week should see the trend reversing and

4/ stocks had been falling for 8 weeks in a row before this upswing so the downward trend is still intact.

Traders’ reactions struck us as excessive especially as no attention had been paid to a 24,000 b/d cut to US production or the (temporary) stoppage at Libya’s largest oil field, EL Sharara (270,000 b/d) due to strike action. Oil fundamentals are still generally upbeat but the market is choosing to see the “half empty glass” side of things. We expect Brent crude to stick to the low end of the USD 50-60 trading range in coming months before rising when the fall in inventories picks up speed in the third and fourth quarters of this year.

Elsewhere, gold returned to last November’s highs (USD 1,275-1,300/oz) when the US jobs report for May came in much lower than expected. Even though this does not undermine the expected rate hike this month, the Fed’s message will be cautious and rate increases limited. Gold also gained on news that the Indian government was to levy a 3% tax on jewellery –the Goods and Services Tax- but this only represented a 1% increase on current rates which was less than expected.

Corporate debt

Credit

The UK elections deprived the Tories of a parliamentary majority, plunging sterling, the economy and Brexit talks into uncertainty. It is already clear that Theresa May will not have the power to negotiate a hard Brexit. So far, however, no major contagion on European credit markets. The iTraxx Main and Xover were more or less unchanged over the week at 62bp and 249bp respectively.

On the new issues market, UPC Holding (Ba3/BB-) raised EUR 635m at 3.875% over 12 years. The deal had no effect on net leverage and the proceeds will be used to refinance the company’s 2022 6.375% senior bonds. Senior Industries (B/B2) issued a senior 8NC3 bond at 6% for EUR 250m.

The big news over the week was Banco Popular’s symbolic one euro sale to Santander. AT1 debt had previously been written off and Tier 2 debt converted into equity. It was an orderly bankruptcy that used the unique resolution mechanism for the first time. The procedure is the EBU’s second pillar and is meant to protect savers and preserve a troubled bank’s commercial activity. The resolution is not expected to trigger systemic risk in Spain but it does open the door to sector consolidation in the country.

Newlook (B3/B) saw like-for-like sales fall by a disappointing 6.6% to GBP 1.45bn and a 32% plunge in Ebitda. Margins fell from 15.2% last year to 10.7%. Leverage rose to 7.4 times from 4.7 times a year ago. The difficulties arose from sales drives and higher spending on marketing and networks. Management said the environment would remain very competitive in 2017 as a whole.

Convertibles

In a busy week for new issuance, Bayer went for a jumbo deal, issuing a EUR 1bn convertible at 0.05% due 2020 exchangeable into German plastics and polymers manufacturer Covestro while simultaneously placing 8.5% of Covestro’s equity and thereby reducing its stake to 44.8%. The proceeds from both deals will go in part on the Monsanto acquisition.

French supermarkets operator Carrefour came to market with a USD 500m non-dilutive convertible bond due 2023.

There were 3 US deals; Liberty Expedia Holdings (a holding company with a 15.6% stake in Expedia) raised USD 350m at 1% with a bond exchangeable into Expedia shares. The proceeds will be used on refinancing. BlackRock Capital Investment Corporation, a business development company, issued raised USD 125m at 5% due 2022 to repay debt. Invacare Corporation, a manufacturer and distributor of medical equipment, announced a USD 100m convertible with a 4.5% coupon and 32.5% issue premium to be used on working capital.

Elsewhere, Steinhoff (South African discount retailer) unveiled disappointing first half results and the stock lost 7% in 3 days. Total revenue rose by 48% and operating profit by 13% yet the company’s restructuring of Mattress Firm is likely to remain weak for the end of the year (product transition will occur in Q3).

In Japan, Sony once again delayed the sale of its battery business to Murata. The deal was originally expected by early July but is now slated for September due to “a longer than expected regulatory review process”. In the US, Microchip Tech (semiconductors) raised its June quarter guidance for net sales and EPS based on “the strength of the current business”.